May 3, 2022:
In this article we’re going to discuss signs of a bursting US growth stock bubble, the downturn in global markets more broadly, our investment outlook, and a good investment you can make on your own.
How’s the bubble doing? (short answer: not well)
First, interest rates have increased dramatically, which is important because super-low rates were used as a rationalization for high growth stock valuations. This narrative has been blown to pieces with the rapid move up in rates. (The historic decline in the bond market is worth discussing on its own — more on that in the next section).
Second, growth stocks have continued the decline that began earlier this year, and the pain has continued to spread from the smaller growth companies to the large ones. Even most of the FAANG stocks (a popular acronym for the dominant and seemingly untouchable platform companies) have been hit hard. Here’s how far down the FAANGs are from their recent peaks:
- 45% of stocks in the index are down over 50%
- 22% of stocks are down over 75%
- 5% of stocks are down over 90%
Small stocks have taken the brunt of it, but the “FAANG” table above shows that the decline has spread to the broader growth stock universe. All in all, US growth stocks are down 23% from their peak. (2)
But despite the decline to date, US growth stocks still look extremely expensive . This can be seen in the next chart, which shows the relative valuation of US value and growth stocks (a lower number here actually means that growth stocks are relatively overvalued). Even after the recent decline in growth stocks (the line moving up), there is still a long way to go before the huge relative mispricing is normalized: (3)
Historically, deflating bubbles have caused dramatic shifts in market dynamics compared to what investors had become accustomed to. At the height of the dot-com bubble, for instance, investors were used to the constant dominance of technology stocks and assumed it would never end. Once things turned over, though, the former dominators fell longer and farther than the rest of the market. Meanwhile, reasonably priced areas of markets bottomed much sooner and at much higher levels, and then proceeded to match or outperform tech stocks for years on the way back. (4)
Major bubbles are generational events that change the course of markets for years or even decades in their wakes. If this is such an event — and we think the evidence is pretty solid that it is — avoiding the bubbly markets and sticking to the reasonably priced ones will be of utmost importance.
Nowhere to hide
While the pain was mostly limited to bubble areas at first, it has spread to encompass most areas of the market.
Bonds don’t get as much press as stocks but the inflation-driven decline in bond markets is one for the ages. The overall US bond market has declined by 10% just since the beginning of the year. Given that it was yielding only 1.8% at year end, this equates to a loss of over 5 years’ worth of income! The US bond market has rarely had a more rapid decline, and it’s not just happening here: according to Bloomberg, the global bond market just experienced its worst decline on record. (5)
Sharply rising interest rates tend to be negative for stocks, for reasons we discussed in last year’s article about inflation. And this is all happening on top of, and partly because of, serious geopolitical crises: first the Russian invasion of Ukraine (discussed in our most recent article), followed more recently by Covid-related lockdowns in China.
Putting it all together, it’s been a rough period for stocks overall: the global stock market has declined 15% from its peak. (6)
We’ve been avoiding interest rate risk for a while, so we haven’t had much direct effect from the bond market meltdown. And while our stock holdings have suffered as broad markets have fallen, our generally cautious stance has cushioned some of the decline.
In our February article we actually discussed the potential effect on our holdings in the face of a broad market downturn, and we think it still applies:
“If markets continue downward – and especially if the bubble bursts in earnest – we’ll probably participate in that too, at least to some degree. It’s not realistic to expect that our stock holdings will keep going up through a protracted market decline. (And trying to avoid the downturn altogether [by going to cash] would be too risky in our view, as we described in an article last year). Our goal is to weather any downturn that comes along, and to take advantage of it by picking up cheap investments that have been caught in the crossfire of a general market selloff.”
Where could things go from here?
While everything has recently been moving down together, the likely prospects for various markets look very different. History suggests that once the storm passes, the investments that started out reasonably valued will recover soon enough. The bubble investments, in contrast, seem to be facing the long, painful slog to reasonableness that has characterized past bubble bursts.
When might the storm pass for the non-bubble investments? We wish this could be known, but we don’t think it can. We’ve written about the risks of trying to time such things, and also about how wars, as tragic and newsworthy as they are, tend to have a somewhat fleeting market impact. We saw in 2020 that the market effects of Covid lockdowns, such as those now happening in China, can be short-lived. And while inflation and rising rates are serious concerns, the markets have gone a long way towards pricing in those outcomes (and in any case, value stocks, to which we are heavily tilted, have historically fared a lot better in inflationary times). (7)
Nobody can know when these economic and geopolitical events will change course. So we are hanging on to our reasonably priced, fundamentally sound investments, and waiting for the storm to pass.
A silver lining here is that some valuations are starting to look really good again. Some of the asset classes we own are now priced to deliver double-digit estimated annual returns over the next 7 years. (8) Such opportunities don’t come along often, and we’ll gladly take them when they do. And to the extent that the decline gets worse before it gets better we have dry powder to pick up any bargains that come along.
Investment opportunity: High inflation = high interest rates on I Bonds
As a result of the current high inflation numbers, a little known type of US Savings Bond called a Series I Bond has recently become very attractive because its rate is directly tied to the inflation rate.
The rate in I Bonds changes every 6 months and on May 1 it adjusted to 9.62%. We think that the I Bond yield will be significantly better than cash for quite some time.
A couple additional positives are that the interest is state tax free and all interest is tax deferred until withdrawal. Furthermore, I Bond values do not decline — you are assured of seeing your balance higher.
The downsides are:
- This isn’t something that we can buy for you or help you set up. You can only purchase straight through the government at the Treasury Direct website.
- There are limits of 10k per person per calendar year and another 10k on top of that for those who have a trust.
- You can’t withdraw the money for 12 months. For 4 years after that, there is a minor penalty for withdrawal (the last 3 months’ worth of interest.)
- They can’t be purchased in IRAs.
If you have money in the bank that you don’t need for at least the next 12 months, this could be an option to consider. If you don’t have money in the bank, but want to invest in I Bonds and have a non-retirement investment account with us or elsewhere, you can distribute some of that money and then invest it in the I Bonds for as long as they are attractive. To learn more about I Bonds see this help page at the Treasury Direct site.
Excerpted from a letter sent to clients on May 2, 2022.
- Source: Jason Goepfort/SentimenTrader, 4/29/22
- Source: Google Finance (ticker VUG; this and all Google Finance data as of 5/2/22). By the way — Tesla, which we’ve criticized as a bubble poster child, is down 27% from its peak. This is somewhat worse than the average growth stock, but not as bad as we would have expected given what’s going on with the other former high-flyers. We suspect that Tesla is particularly vulnerable should the bubble continue to break down.
- Source: GMO. This chart is through March 31. Growth stock valuations have come down a bit since then, but not enough to change the big picture. According to stockcharts.com, US growth underperformed US value by about 8% since that date, which still leaves growth more overvalued than at any time outside the dot-com bubble and this current situation.
- For example, see the relative performance of EM value stocks in this article and of US small value stocks in this one.
- Sources: Koyfin (ticker AGG), Bloomberg
- Source: Google Finance (ticker VT)
- Source: GMO
- Based on estimates by GMO, updated to reflect recent price changes, both EM value stocks and Japan small value stocks are forecasted to deliver double-digit nominal returns over the next 7 years.